The penny is mightier than the sword

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Summary: The jailing of Russian oil tycoon Mikhail Khodorkovsky has revealed the fault lines running through the post-Soviet political economy. The reforms and privatization of the 1990s were so flawed and unfair as to make them unstable. A backlash was inevitable. Given Vladimir Putin’s authoritarian tendencies, that backlash has proved equally flawed and unfair-and perhaps equally unstable.

Marshall I. Goldman is Kathryn W. Davis Professor of Russian Economics, Emeritus, at Wellesley College, Associate Director of the Davis Center for Russian and Eurasian Studies at Harvard University, and the author of The Piratization of Russia: Russian Reform Goes Awry.

THE KHODORKOVSKY AFFAIR

In mid-September, Russian President Vladimir Putin announced plans for a radical overhaul of his country’s political system, with the goal of centralizing power in the Kremlin. Acting in the wake of the hostage crisis in Beslan, during which Chechen separatists killed hundreds of children, Putin claimed that his power grab was necessary to help Russia win its own war on terrorism. Whatever his motivations, the move represents a major step backward for Russian democracy.

Putin’s recent actions may be the most drastic of his tenure so far, but they were hardly the first signs of his willingness to deploy the power of the Russian state for his own purposes. A year earlier, he had Mikhail Khodorkovsky, the head of the oil group Yukos and one of the world’s richest men, arrested and thrown in jail on charges of fraud and tax evasion-a move widely interpreted as a declaration of war against the so-called oligarchs, who have amassed phenomenal wealth and power since the collapse of the Soviet Union in 1991. A key question now is whether Khodorkovsky’s arrest is the forerunner of what will happen to many of his business colleagues.

The Khodorkovsky affair has been a shock for those who had come to believe in the “new Russia.” During the previous dozen years, Russians had rejected the Communist Party and the Soviet Union’s command economy. To the applause of most of the outside world, Russian and foreign economic advisers drew up an elaborate program for the privatization of industry, housing, and land. In an attempt at “people’s capitalism,” virtually every Russian was issued a voucher good for shares in a soon-to-be-private enterprise. Stock markets sprouted almost everywhere, while industrial ministries gave way to privately owned, Russia-based multinational corporations.

The largest of these corporations were producers of petroleum, natural gas, or metal that had previously been controlled by a Soviet industrial ministry. Their new executives became dazzlingly wealthy almost overnight. In May 2004, the Russian edition of Forbes identified 36 of these oligarchs as being worth at least $1 billion. Khodorkovsky topped the list with an estimated net worth of $15 billion.

These events appeared to signal the triumph of the market and private industry. To be sure, there were unsettling reports of shady dealings during the takeovers, but most observers explained them away as inevitable side effects of such a far-reaching transformation. After all, did the United States not once have its own robber barons, who, despite early roughhouse tactics, became the leaders of some of the country’s most prominent corporations and the benefactors of its most respected charities and foundations? Besides, many argued, it was only a matter of time before the Russian government would intervene to correct the most flagrant misbehavior, much as Theodore Roosevelt did with the passage of the Sherman Antitrust Act and other Progressive reforms during the early years of the twentieth century.

The difference in Russia is that the basic reforms and privatization of the 1990s were so flawed and unfair that they created an unstable business environment. A radical resettling of existing ownership arrangements was thus all but inevitable. And given Putin’s authoritarian tendencies, it is hardly surprising that when the move came it was equally flawed and unfair-and perhaps equally destabilizing. What has happened to Khodorkovsky and nine of his now-jailed or exiled senior associates is, in short, more than the dramatic saga of a rich man’s fall from grace or a despot’s capricious revenge: it is a window onto the cracks that run through Russia’s post-Soviet political economy.

OIL SLICKS VS. GOVERNMENT STIFFS

The reforms of the 1990s were mainly the work of the advisers brought in under then president Boris Yeltsin. Fearing that the population might soon have a change of heart and turn its back on reform, Yegor Gaidar and Anatoly Chubais, the chief Russian architects of the process, decided to accelerate it, selling off state resources and enterprises at little or no charge. Not long into the process, ownership of some of Russia’s most valuable resources was auctioned off by oligarch-owned banks under a scheme called “Loans for Shares.” Although they were supposedly acting on behalf of the state, the bank auctioneers rigged the process-and in almost every case ended up as the successful bidders. This was how Khodorkovsky got a 78 percent share of ownership in Yukos, worth about $5 billion, for a mere $310 million, and how Boris Berezovsky got Sibneft, another oil giant, worth $3 billion, for about $100 million.

When it came to dealing with the oligarchs, the government was generally unable to exercise much control. Since the state was very weak, these “new Russians” paid little or no taxes on their purchases. And if most American robber barons had at least created something out of nothing, the Russian oligarchs added nothing to what already was something. Virtually all their wealth came from the seizure of Russia’s raw material assets, which until 1992 had been owned and managed by the state. An oligarch’s success, in other words, almost always depended on his connections to the government officials in charge of privatizing the country’s rich energy and mineral deposits, as well as on his ability to outmaneuver or intimidate rivals. (Two senior Yukos executives have been charged with murder and attempted murder, and the mayor of Nefteyugansk, where Yukos’ major producing unit is headquartered, was murdered after criticizing the firm’s failure to pay taxes.)

By the time Putin succeeded Yeltsin in 2000, there was much to remedy. One of Putin’s first steps was to declare a change in the rules of the game. As he put it in a meeting with the oligarchs in February 2000, “It is asked, what then should be the relationship with the so-called oligarchs? The same as with anyone else. The same as with the owner of a small bakery or a shoe repair shop.” That Putin said this at a special meeting with the oligarchs and not with a group of bakers or cobblers is beside the point; the statement was taken as a signal that the tycoons would no longer be able to flout government regulations and count on special access to the Kremlin. In July of that year, Putin told the oligarchs that he would not interfere with their businesses or renationalize state resources as long as they stayed out of politics-that is, as long as they did not challenge or criticize the president. Although the promise provided some reassurance, it also displayed a warped concept of how markets, businesses, and the state are supposed to function in a democracy.

Limiting the oligarchs’ political involvement proved difficult. As more people grew richer, some were inevitably tempted to expand their activities beyond business. Several, including Vladimir Gusinsky and Berezovsky, created media empires of television stations, newspapers, and magazines and used these outlets to attack not only each other, but also Putin, particularly for his policies in Chechnya and his inept response to the 2000 sinking of a nuclear-powered submarine in the Barents Sea.

As Putin started to feel betrayed by the oligarchs politically, others found themselves victimized economically. Investors in Khodorkovsky’s projects regularly found that they had acquired worthless pieces of paper. The American investor Kenneth Dart had to write off an estimated $1 billion. The oil company then known as Amoco (and later as BP Amoco) had a similar experience. Both had put money into an oil-producing subsidiary that Khodorkovsky seized and stripped of its assets. Similarly, when the Russian company Tyumen Oil stripped the assets of a Sidanko Oil subsidiary, BP Amoco had to write off, at least temporarily, $200 million of its $500 million investment in Sidanko Oil.

After the Russian government declared a moratorium on the repayment of its debt on August 17, 1998, most Russian banks, including Khodorkovsky’s Menatep, simply closed their doors, depriving hundreds of thousands of ordinary Russians of their savings. Rather than try to help depositors and other lenders, Khodorkovsky took whatever sound assets he could salvage and diverted them to a subsidiary in St. Petersburg, beyond the reach of his creditors. After lengthy and often halfhearted intervention by the government, Menatep eventually agreed to provide token compensation; so did Yukos, to those who had taken its stock as collateral for loans to the company. But by the time Khodorkovsky was through issuing new shares and watering down the old stock, few of the banks’ depositors or lenders had much to show for their efforts.

Still, it was less Khodorkovsky’s financial skullduggery than it was his interference in political matters that upset Putin. Khodorkovsky was reported to have offered Russia’s two liberal parties, Yabloko and SPS (the Party of Right Forces), $100 million to unite and campaign together in opposition to Putin and his United Russia Party. And he broadly hinted that he would run for president in 2008, when Putin’s term is due to expire.

Khodorkovsky also actively promoted legislation that would benefit Yukos. It was said that, to ensure such support, he bought control of as many as 100 seats in the Duma (the lower house of the Russian parliament), including several held by members of the Communist Party. Whether the rumors were true or not, he was able to head off attempts by the Duma to increase taxes on petroleum producers in 2001 and 2002.

Such heavy-handed lobbying is hardly unknown in the U.S. Congress, especially on energy matters, but to Putin it represented a violation of the deal he had offered the oligarchs. The siloviki, the law-and-order types from the KGB, the police, and the army that Putin had been bringing into the government, felt the same way. Khodorkovsky’s methods were a fundamental challenge to their control of the country-or, as one noted, “a danger and threat to the Russian state.”

FLEECING THE BEAR

Ironically, just a few years earlier, Khodorkovsky had decided to turn over a new leaf, at least in financial matters, and he started to change the way he ran his business. In 1999, he espoused the importance of transparency for himself and his fellow oligarchs. He hired Western accounting firms, and Yukos became one of the few Russian companies to acknowledge who its main stockholders were. It began to pay back wages to its employees and publish a more complete statement of its tax obligations. Khodorkovsky reorganized Yukos’ board of directors, bringing in several well-respected Western investors, lawyers, and businessmen. He also established the Open Russia Foundation, a charity supporting educational and cultural projects, and recruited Henry Kissinger, Lord Rothschild, and Arthur Hartman, the former U.S. ambassador to the Soviet Union, for its board. Once he had made his billions, he, like the American robber barons, decided it was time to become charitable and play by the rules.

As many in the West applauded these changes, Khodorkovsky became increasingly self-confident and even brazen. Eager to export more oil, he called for the building of new pipelines: one to the Arctic port of Murmansk (a base for exports to the United States), another through Siberia (toward Asian markets). For the latter, he favored a pipeline to China, despite the government’s preference for a route to the Pacific, which would serve Japan. Although both proposals already were a direct challenge to Transneft, the state monopoly that owned and operated all of Russia’s pipelines, Khodorkovsky announced that he was prepared to build his own pipelines if necessary.

To top it off, at a February 2003 meeting in the Kremlin, Khodorkovsky complained to Putin that the executives of a state-owned oil company, Rosneft, had overpaid for a smaller company in a sweetheart deal. (He was angry because Yukos had also been interested in the company but had refused to buy it at what it considered an inflated price.) Khodorkovsky’s denunciation of Rosneft was an open challenge to Putin because Rosneft’s head, Sergei Bogdanchikov, was closely associated with the siloviki. More and more, it appeared that, with his immense wealth, control over what was about to become the world’s fourth-largest oil company, and considerable influence in the Duma, Khodorkovsky saw himself as beyond the control of the Kremlin. No businessman had ever reached that point before, neither under the tsar nor under Yeltsin, and Putin was determined not to let it happen on his watch either.

Khodorkovsky’s financial shenanigans were hardly exceptional. The authorities could have brought similar charges of underpayment, tax evasion, bribery, murder, or attempted murder against many of the oligarchs. It was the audacity that Khodorkovsky and his Yukos subordinates displayed in interfering directly in politics that made them a special target. Like Gusinsky (who was jailed for a time) and Berezovsky (who was exiled) before him, Khodorkovsky provoked Putin by criticizing him and supporting opposition parties and candidates.

To those who believe in the supremacy of the state-as most Russians do-Khodorkovsky’s aggressive behavior was suspect on any number of counts. An even more basic question, however, was whether he has the right to claim for himself so much of the wealth that had until recently belonged to the state or, supposedly, to the people at large. This issue loomed increasingly large for the Kremlin and the siloviki. From their perspective, the oligarchs had done nothing to deserve such good fortune. The country’s resources had been stolen through the manipulation of a poorly conceived privatization process, thanks to rigged bids, bribes, violence, and dubious interpretations of the law. Until late 1999, moreover, almost none of the oligarchs had done much to restructure or improve the assets they had acquired from the state.

As a few private individuals seized state property, a third of Russia’s population was thrust below the poverty line, exacerbating public resentment over such radical redistribution of wealth. According to a recent poll, 77 percent of Russians feel that privatization should be either fully or partially revised. Only 18 percent oppose renationalization. Many of those interviewed were also unhappy with the market system in general and sought to discredit the whole privatization process.

The siloviki, meanwhile, had become concerned that access to and ownership of more and more of Russia’s mineral deposits were being sold to foreign multinational corporations, including some owned predominantly by Americans. By the time of Khodorkovsky’s arrest in October 2003, Tyumen Oil had formed a partnership with BP, and several other companies (such as ConocoPhillips) were secretly engaged in similar negotiations. When Khodorkovsky, after announcing a pending merger between Yukos and Sibneft, began to negotiate with both ExxonMobil and Chevron-Texaco, government hard-liners grew truly alarmed. They feared that Putin would wake up one morning and discover that Russia’s most strategic and valuable energy companies had been taken over by Western corporations. It was one thing for the foreign companies to be minority investors, but quite another for them to buy operational control, especially when some of their payments to the oligarchs were being diverted abroad. Roman Abramovich’s purchase of London’s Chelsea soccer team for $400 million may have pleased Londoners, but it angered Moscow’s mayor, Yuri Luzhkov, who wanted to know why the money was not going to improve a Moscow team instead.

That many of the oligarchs were Jewish also helped revive some old and ugly prejudices. It was only a matter of time before a Russian nationalist like Alexander Tsipko dusted off the image of “Jewish capital” from the tsar’s days, claiming (incorrectly) that Khodorkovsky had arranged for the transfer of his “stake in Yukos to the guardianship of Lord Rothschild’s Institute of Jewish Policy Research in Britain” if anything happened to him.

In short, the oligarchs were an easy target. After Khodorkovsky’s arrest, Putin’s poll ratings rose from an already high 70 percent to an impressive 80 percent. In addition, running on the slogan “Russia for Russians,” Rodina, a nationalist political party only a few months old, was able to win nine percent of the vote in Duma elections two months later. Most Russians feel, with good reason, that if the country’s economic reforms in general, and privatization in particular, had been carried out more honestly and equitably, the economic results would have been better, the country’s income disparities less pronounced, and control over its resources more widely dispersed.

PUTIN’S HEAVY HAND

If it is difficult to defend Khodorkovsky and most of the other oligarchs, it is equally difficult to justify the methods Putin used against them. The machinations of the siloviki have been particularly aggressive. According to the sociologist Olga Kryshtanovskaya, the siloviki now constitute 50 to 70 percent of the Kremlin’s staff. Although most are not proponents of communism, they do seek to restore power to the state and ensure that the security forces regain a central, if not commanding, role in Russian politics. As Rosneft’s Bogdanchikov, a key siloviki ally, boasted, “three days in Butyrke Prison and [Khodorkovsky and his aide Roman Lebedev] will understand who is the master of the forest.”

To prevent the transfer of Yukos’ ownership to Western companies, state authorities ordered the seizure of 40 percent of Yukos’ stock, along with Khodorkovsky’s arrest. They also sought to force Khodorkovsky and his aides to transfer control of the company to the state or at least to a more sympathetic Russian owner. Threats against Gusinsky had brought good results: after a few days in prison in a cell with common criminals, some of whom were thought to be infected with HIV, he had signed over his shares in Media Most to Gazprom, Russia’s state-controlled gas monopoly.

But the Yukos executives were more resolute. Despite being denied bail and given ever-lengthening prison terms, they refused to turn over their shares. They held out in the face of the prosecutor’s warnings that their sentences might stretch from days, weeks, and months into decades. Bemoaning the fact that “sadly, it is impossible to give Khodorkovsky a longer term” than ten years, Deputy Prosecutor-General Vladimir Kolesnikov suggested that the law be amended to extend the maximum term. And to deter anyone who might be tempted to come to Khodorkovsky’s defense, Kolesnikov warned, “Let those who are not yet in jail think hard about what they are doing.”

Arresting rich businessmen, even billionaires, is no longer a novelty in Russia or elsewhere. But in Russia they are arrested by masked men armed with machine guns, and they are denied bail. Those who are not jailed are increasingly pressured to accept siloviki as partners or return ownership to the state, lest their corporations be stripped of their value. The Natural Resource Ministry has already revoked Yukos’ license to drill in some parts of Siberia. In July, the Ministry of Justice threatened to seize the company’s largest subsidiary, Yuganskneftegaz, which is worth between $17 billion and $24 billion. Contemplating, ironically, a favorite tactic of Khodorkovsky’s, for a time the government considered underpricing the asset and selling it off for only $1.75 billion, as partial payment for the company’s $3.4 billion tax bill for the year 2000. At that rate, Yukos would not be able to pay its bill for 2000, or for any year since.

There are those in the Kremlin who would see such a sale as a golden opportunity for the state and the siloviki to regain control from people they consider to be undeserving hucksters. As a sign of what might be ahead, Igor Sechin, a senior Kremlin aide to Putin, has also just been appointed chairman of Rosneft, the state oil company. (His daughter just married the son of Vladimir Ustinov, Russia’s chief prosecutor-general in charge of the Yukos case.) A few weeks later, Putin announced that Rosneft would be merged into Gazprom. As Russia’s largest company, the new state-controlled entity would thereby become the most likely candidate to pick up Yuganskneftegaz should Yukos be forced to sell it off to pay taxes.

REFORMING THE REFORMS

Any examination of how Russia has come to find itself in such a situation must begin with a look at the original privatization process. The architects of the reforms can rightly claim that their blueprint achieved its main objective: the communists have not regained control of the government. But by moving so quickly to privatize state resources while failing to encourage the startup of new businesses, the reformers inadvertently paved the way for the rise of the oligarchs-and for the state’s counterattack. And as the 2003 election results demonstrated, the oligarchic seizure of Russia’s resources triggered support for the neo-nationalists-whose agenda is not all that different from that of the communists, at least not when it comes to the state’s regaining control of mineral resources.

In response to these political trends, in April, Russia’s State Audit Chamber-the equivalent of the U.S. Government Accountability Office-convened a one-day retreat with three Americans and four Europeans to consider what might be done to redress abuses of the privatization process. Its final report is expected by the end of this year, but Russian officials have said in an interim report that inspections of 140 privatized companies have revealed 56 violations of state regulations. Igor Shuvalov, one of Putin’s economic advisers, later warned that Yukos would not be the last company to find itself under attack.

The return of the statists and their push for redress are bound to unsettle existing and potential private investors, Russian and foreign. Certainly, BP should be worried about the $7 billion it has already invested in a partnership with Tyumen Oil, a company that has been accused of misbehavior similar to Yukos’, including abuse of the legal system, unfair payment for state resources, and tax delinquency. The partnership itself has also been charged with violating the official state secrets act by disclosing the extent of the country’s petroleum reserves, even though it is information that the partnership’s senior executive officers needed to know. State prosecutors and tax authorities have also raided the offices of Sibir Airlines, the metal producer RusAl, and the oil company Sibneft (which paid taxes on only 7 percent of its profits, less than a third of the statutory rate and half of what Yukos paid).

Foreign investors have not been spared, either. A 1993 tender for development on Sakhalin Island by an ExxonMobil-led consortium was suddenly revoked in February after the consortium was accused of failing to invest as much as it had promised. Since almost all the privatization efforts have involved underpayment, cutting corners, tax avoidance, intimidation, or outright physical force, every new owner has to fear that, if he can be identified, someday a government agency will also single him out for harassment. As a result, the crackdown may have unintentionally set back efforts to make Russian business more transparent.

Recognizing the anxiety that these measures have triggered, Putin has tried to reassure the business community. He made a point of meeting with James Mulva, the CEO of ConocoPhillips, to encourage him to bid for the shares the state still holds in Lukoil. In a December 2003 meeting with the Russian Chamber of Commerce, moreover, Putin noted, “If five, seven, or ten people broke the law, that doesn’t mean the others did the same. The rest may not have made as much money, but today they sleep soundly.”

This is hardly comforting. Who knows which five, seven, or ten of the 5,500 or so privatized businesses Putin was referring to? And if the past is any precedent, it would be unusual, as the State Audit Chamber report suggests, for so few companies to come under scrutiny in the end. So despite Putin’s reassurances, most of those who benefited from privatization will see Khodorkovsky’s imprisonment as a warning of what could happen to them if they get too ambitious or challenge the Kremlin.

Russia will undoubtedly survive the flawed process of privatization, just as it has survived more serious crises. But the direction Putin is taking is disappointing. By merging state-controlled Gazprom with state-owned Rosneft, he has signaled once again that the state will become a strong if not dominant voice in energy policy and economic planning. Moreover, the new entity has become the most likely suitor for Yuganskneftegaz once, as seems likely, Yukos is forced to sell it. If the purchase occurs, Gazprom-Rosneft will then account for 25 percent of the country’s energy production. Combined with Putin’s crackdown on the media and his September order to terminate the direct election of governors and members of the Duma, his increased involvement in economic matters is worrisome. It means that, under Putin, Russia is reversing some of the most important economic and political reforms it adopted after freeing itself from the yoke of communism.